WASHINGTON (AP) — The government on Friday accused Wall Street’s most powerful firm of fraud, saying Goldman Sachs & Co. sold mortgage investments without telling the buyers that the securities were crafted with input from a client who was betting on them to fail.

And fail they did. The securities cost investors close to $1 billion while helping Goldman client Paulson & Co., a hedge fund, capitalize on the housing bust. The Goldman executive accused of shepherding the deal allegedly boasted about the “exotic trades” he created “without necessarily understanding all of the implications of those monstrosities!!!”

The civil charges filed by the Securities and Exchange Commission are the government’s most significant legal action related to the mortgage meltdown that ignited the financial crisis and helped plunge the country into recession.

The news sent Goldman Sachs shares and the stock market reeling as the SEC said other financial deals related to the meltdown continue to be investigated. It was a blow to the reputation of a financial giant that had emerged relatively unscathed from the economic crisis.

Goldman Sachs denied the allegations. In a statement, it called the SEC’s charges “completely unfounded in law and fact” and said it will contest them.

The SEC is seeking to recoup the money lost by investors and impose unspecified civil fines against Goldman Sachs and the executive, Fabrice Tourre. The SEC could enter into settlement negotiations over the amount if Goldman changed its stance and decided not to fight the charges in a trial.

The SEC said Paulson paid Goldman roughly $15 million in 2007 to devise an investment tied to mortgage-related securities that the hedge fund viewed as likely to decline in value. Separately, Paulson took out a form of insurance that allowed it to make a huge profit when those securities’ value plunged.

The fraud allegations focus on how Goldman sold the securities. Goldman told investors that a third party, ACA Management LLC, had selected the pools of subprime mortgages it used to create the securities. The securities are known as synthetic collateralized debt obligations.

The SEC alleges that Goldman misled investors by failing to disclose that Paulson & Co. also played a role in selecting the mortgage pools and stood to profit from their decline in value. Two European banks that bought the securities lost nearly $1 billion, the SEC said.

“Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party,” SEC Enforcement Director Robert Khuzami said in a statement.

But Goldman said in a statement that it never mischaracterized Paulson’s strategy in the transaction. It added that it wasn’t obliged to “disclose the identities of a buyer to a seller and vice versa.”

The charges name only Goldman Sachs and Tourre, who was a vice president in his late 20s when the alleged fraud was orchestrated in 2007. Tourre, the SEC said, boasted to a friend that he was able to put such deals together as the mortgage market was unraveling in early 2007.

In an e-mail to the friend, he described himself as “the fabulous Fab standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

Tourre, 31, has since been promoted to executive director of Goldman Sachs International in London.

Stanford University spokeswoman Elaine Ray said a student by the name of Fabrice Tourre received a master’s degree in management science and engineering from the school in 2001.

A call to a lawyer for Tourre, Pamela Chepiga at Allen & Overy LLP, wasn’t returned.

Asked why the SEC did not also pursue a case against Paulson, Khuzami said: “It was Goldman that made the representations to investors. Paulson did not.”

Paulson & Co. is run by John Paulson, who reaped billions by betting against subprime mortgage securities. He is not related to former Treasury Secretary Henry Paulson, a former Goldman CEO.

John Paulson was among the first on Wall Street to bet heavily against subprime mortgages. His firm earned more than $15 billion in 2007, and he pocketed $3.7 billion. He has since earned billions more, largely by betting against bank stocks and then buying them back after their shares plunged.

In a statement, Paulson & Co. said: “As the SEC said at its press conference, Paulson is not the subject of this complaint, made no misrepresentations and is not the subject of any charges.”

Goldman, founded more than 140 years ago, built a reputation as a trusted adviser to investment banking clients and for sending top executives into presidential Cabinet posts.

In recent years, it shifted toward taking more risks with its clients’ money and its own. Goldman’s trading allowed the firm to weather the financial crisis better than most other big banks. It earned a record $4.79 billion in the last quarter of 2009.

The complaint filed in federal court in Manhattan “undermines their brand,” said Simon Johnson, a professor at the Massachusetts Institute of Technology and a Goldman critic. “It undermines their political clout. I don’t think anybody really values being connected to Goldman at this point.”

He continued: “There are many people who — until this morning — thought Goldman Sachs was well-run.”

The SEC’s enforcement chief said the agency is investigating a wide range of practices related to the crisis. The prospect of possible legal jeopardy for other major financial players roiled the stock market.

Goldman Sachs shares fell more than 12 percent Goldman and lost $14.2 billion in market capitalization. The Dow Jones industrial average finished down more than 125 points.

The SEC appears to be taking a particularly aggressive approach with Goldman. Typically, cases are resolved by firms agreeing to a settlement before the charges are made public, said John Coffee, a securities law professor at Columbia University.

“The SEC has changed its style,” Coffee said. “They wanted to tell the world what they thought Goldman had done wrong.”

The charges come as lawmakers seek to crack down on Wall Street practices that helped cause the financial crisis. Congress is considering tougher rules for complex investments like those involved in the alleged Goldman fraud.

President Barack Obama vowed Friday to veto a financial overhaul bill that doesn’t regulate mortgage-backed securities and other so-called derivatives. Legislation in Congress would for the first time regulate derivatives, whose value depends on an underlying asset, such as mortgages or stocks. Senate Republicans oppose the bill.

Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, is “pleased that the SEC is departing from the lax enforcement of the Bush administration and is returning to the SEC’s proper role of protecting investors in the marketplace,” spokesman Steven Adamske said.

The biggest loser in the alleged fraud was ABN Amro, a major Dutch bank, and the Royal Bank of Scotland, which acquired major portions of it in 2007. The SEC said the Royal Bank of Scotland paid Goldman $841 million to unwind ABN transactions.

IKB Deutsche Industriebank AG, a German commercial bank, lost nearly all its $150 million investment, the agency said. Most of the money the banks lost went to Paulson in a series of transactions between Goldman and the hedge fund, the SEC said.

IKB was an early casualty of the financial crisis. It issued a profit warning in 2007 saying it had been hurt by U.S. subprime mortgage investments. IKB was sold in 2008 to Dallas-based Lone Star Funds.

Ed Trissel, a spokesman for Lone Star Funds, declined to comment on the case.

The SEC charges come after Goldman Sachs denied last week it that bet against clients by selling them mortgage-backed securities while reducing its own exposure to them.

In an annual letter to shareholders, Goldman said it began reducing its exposure to the U.S. mortgage market in late 2006.

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AP Business Writers Alan Zibel in Washington, Stevenson Jacobs in New York and Ashley M. Heher in Chicago contributed to this report.